As the regulation of public company audits evolves, questions persist over whether there is still a gap between the public and auditors over expectations for the responsibilities of auditors – what we call the expectations gap. In a recent study, we replicate an earlier study by McEnroe and Martens (2001) (hereinafter “MM 2001”) to determine whether the expectations gap has changed.

In the two decades since MM 2001, events such as audit failures and the issuance of new regulations may have affected the expectations gap. Most notably, large-scale accounting scandals, including those at Enron, WorldCom, and Waste Management, have led to numerous regulatory changes and a public outcry for greater accountability and improvements in financial reporting. The  enactment of the Sarbanes–Oxley Act of 2002 (SOX) led to creation of  the Public Companies Oversight Board (PCAOB), which oversees the audits of public companies, and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 expanded the PCAOB’s oversight responsibilities.

An early PCAOB regulation, Auditing Standard (AS) No. 2, required auditors to provide an opinion report on their clients’ internal controls. The PCAOB also issued AS No. 6, Evaluating the Consistency of Financial Statements, which was designed to help improve the communication around financial statements when restated. In 2011, the AICPA issued Statements on Auditing Standards (SAS) 122, Statements of Auditing Standards: Clarification and Recodification, to provide a clearer delineation of the responsibilities of managers and auditors. In 2017, the PCAOB issued AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion.  This standard requires increased disclosure of auditor responsibilities as well as audit firm tenure. In 2019, auditors were required to start disclosing critical audit matters (CAMs) under AS 3101. All these regulatory changes potentially helped reduce the expectations gap and improve the financial reporting process.

Our analysis surveys and investigates participants’ responses to 15 questions regarding the audit report and auditor responsibility expectations in order to analyze any changes to the expectations gap since MM 2001. More specifically, we investigate survey participants’ perceptions surrounding the meaning of audit report terminology and the auditor’s responsibilities involving certain dimensions of the attest function. Our study analyzes the following areas of the attest function: (1) integrity of the accounting numbers, (2) oversight responsibilities, (3) economic viability of the entity, and (4) fraud.  The analysis tests for differences across the perceptions of auditors, investors, and CFOs. The study obtained responses from 155 participants including 61 auditors, 43 investors, and 51 CFOs.

Two areas of the analysis find that an expectations gap still exists.  One relates to the auditor’s acting as a public watchdog for the audited firm’s creditors, stockholders, and the investing public in the audit.  We find a large expectation gap between the perceptions of the auditors and CFOs versus that of the investors. The authors find that 72.1 percent of investors agree with the statement, “The auditor has performed a public watchdog function for the audited firm’s creditors, stockholders, and the investing public in the audit of the financial statements.” In contrast, only 33.3 percent of auditors and 29.4 percent of CFOs agree with this statement. The investors’ and the auditors’ and CFOs’ reactions to this statement differed significantly.

The second area that continues to show an expectations gap relates to the audit around the effectiveness of a firm’s internal controls. For the survey statement on auditor oversight responsibilities, “The internal controls of the audited firm are effective,” there was a gap of over 20 percent between the auditors’ and the investors’ and CFOs’ responses.  The study finds that 60 percent of the auditors, 81 percent of the investors, and 88 percent of the CFOs agree with this statement. While these two areas of auditor oversight responsibilities – the public watchdog function and assessing whether controls are effective – continue to show an expectations gap between the three populations of auditors, investors, and CFOs, the expectations gap have been eliminated in certain areas since MM 2001.  The elimination of these expectation gaps over time suggests that auditors’ perceptions of their role have improved. We find no evidence of an expectations gap in regard to the following four questions on the participants’ perceptions over certain attest functions:

1. Every item of importance to investors and creditors has been reported or disclosed in the financial statements.
2. The financial statements are free of misstatements resulting from management fraud.
3. The financial statements are free of misstatements intended to hide employee fraud.
4. There are no illegal operations conducted by the audited firm.

Over time, it is likely that changes to audit regulation by Congress, SEC, AICPA, and others have helped restore confidence in the audit function and reduce the expectations gap.

We find that auditors, investors, and CFOs continue to mostly agree on a wide range of qualitative attributes of the unqualified audit report of publicly traded companies. In our analysis, we document the closing of the expectations gap around reporting/disclosing items of importance and areas of fraud. The analysis finds an expectation gap in only two areas: (1) the public watchdog function and (2) the effectiveness of internal controls. We agree with MM 2001 that an education overview should be presented at annual shareholders’ meetings to explain what an audit does and does not encompass.  A question and answer session about the audit for shareholders would also help them understand the role of an audit of a company’s financial statements. Measures over the past 20 years have helped align the perceptions of auditors, investors, and CFOs about the meaning of the audit report and the auditors’ responsibilities over the attest function.

This post comes to us from professors Wendy Heltzer and Mary Mindak at DePaul University. It is based on their recent paper with John E. McEnroe (since retired) entitled, “The Current Status of Auditors’ and Investors’ Perceptions of the Audit Expectation Gap,” available here.